Debating Inflation

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Just as the economy seems to be creeping back to health, a new study by McKinsey & Co. offers finance executives a fresh concern: inflation.

While various commodity prices have spiked over the past few years, the authors argue that low interest rates and high government spending could spark a rise in prices across the board. If the general price level were to increase by an extreme, albeit unlikely, amount — say, 10% to 15% — simply passing along rising costs to customers wouldn’t keep a company in good health, say study co-authors Marc Goedhart, Timothy M. Koller, and David Wessels, all in the consulting firm’s corporate finance practice.

Even if firms can match earnings growth to the pace of inflation — no small feat — they’ll fall behind on cash-flow growth. “Keeping margins and returns on capital constant in times of inflation means that cash flows and value are eroding in real terms,” the authors explain. One risk, Koller says, is that managers may focus too closely on accounting results — specifically, by using historic asset and depreciation values that don’t take higher replacement costs into effect and thus overstate earnings.

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Unfortunately, there’s no perfect solution. Finance executives can create internal reports that increase the value of depreciation and invested capital, Koller says, but even then “you may not be able to push high-enough price increases through to earn your target returns.” Companies can also try to time cash inflows and outflows, since in an inflationary environment, “you don’t want cash, receivables, or loans; you want lots of debt and payables,” says Koller. However, those practices may ultimately harm suppliers and other business partners.

Many finance chiefs are dealing with inflation in a range of specific areas. In his fourth-quarter earnings call, Molson Coors Brewing Co. CFO Stewart Glendinning attributed more than 40% of the increase in the beer maker’s cost of goods sold to increased packaging, barley, and utilities prices; American Axle & Manufacturing Holdings CFO Mike Simonte recently told analysts he expects to offset inflation in materials prices with productivity gains.

But even a successful navigation of those challenges is unlikely to help in an inflationary environment. “Being good at dealing with specific price increases may not help you deal with general price increases,” says Koller, since substitute options decrease dramatically.

The good news? “We’re not going to see 15% or even 10% inflation,” says Chris Varvares, president of research firm Macroeconomic Advisors. He notes that consensus forecasts from both the National Association of Business Economists and the Blue Chip Economic Indicators expect inflation to be below 2% in both 2010 and 2011. At this point, says Varvares, “there’s a greater risk of deflation than there is of 10% inflation.”